Yvonne's $40,000 and the Ledger That Taxes Gain First
Yvonne, age 68, bought a nonqualified fixed deferred annuity five years ago with a single $200,000 premium. The contract value is now $246,000. The surrender charge is currently 5%, declining one percentage point each year, and the contract permits one free withdrawal each year equal to 10% of contract value. Yvonne needs $40,000 for a roof replacement. She also owns a second nonqualified annuity worth $130,000 with a $100,000 cost basis, and is considering a 1035 exchange into a new contract that carries a fresh seven-year surrender schedule. Her marginal federal income tax rate is 24%, she has adequate other savings, and she is not yet receiving Social Security.
1. Calculate the cost of taking $40,000 from the first annuity now, including surrender charges and federal income tax.
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Surrender charge. The free withdrawal is 10% of $246,000 = $24,600, taken charge-free. The remaining $40,000 − $24,600 = $15,400 is subject to the 5% charge = $770.
Taxation. Nonqualified annuity withdrawals are taxed gain-first (LIFO). The contract has $246,000 − $200,000 = $46,000 of gain. Because the gain exceeds the withdrawal, the entire $40,000 is ordinary income: $40,000 × 24% = $9,600 federal tax. (No 10% premature-distribution penalty applies - she is over 59½.)
Net to Yvonne: $40,000 − $770 − $9,600 = $29,630.
After the withdrawal her basis stays at $200,000 and the contract value falls to $206,000, so only $6,000 of gain remains.
Planning point: if the roof can wait a few months, she could take $24,600 now and the balance after January 1, when a new free-withdrawal allowance (roughly 10% of the then-value, about $22,000) exceeds the $15,400 needed - eliminating the $770 charge entirely. The income tax is the same either way.
2. Evaluate the proposed 1035 exchange of the second annuity. What is required for it to be tax-free, and what should Yvonne weigh before doing it?
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Mechanics. A 1035 exchange from one annuity to another is tax-free only if the funds move directly between insurers (trustee-to-trustee). If Yvonne takes a check payable to herself she has constructive receipt, and the $30,000 of gain becomes taxable ordinary income - $7,200 at 24% - even if she reinvests it days later.
Basis. Her $100,000 basis carries over to the new contract. The exchange is a deferral, not an elimination: the $30,000 of gain is still inside the new contract and will be taxed LIFO when withdrawn.
What she gives up. The new contract restarts a seven-year surrender schedule, replacing a contract already five years into its own. She is 68 and just demonstrated a need for liquidity; trading a nearly-expired surrender charge for a fresh seven-year one is the central cost. She should also compare guaranteed minimum rates, mortality and expense charges, and any new market value adjustment.
The exchange can be justified if the new contract's guarantees and lower ongoing costs outweigh the renewed liquidity restriction - but the surrender schedule, not the tax treatment, is the deciding factor here.
3. If Yvonne instead annuitized the first contract over her lifetime, how would each payment be taxed, and how does that compare with the withdrawal she is contemplating?
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Annuitization changes the tax pattern from gain-first to proportional. The insurer computes an exclusion ratio = investment in the contract ÷ expected return (expected return being the monthly payment multiplied by the number of payments under the payout option). That percentage of each payment is a tax-free return of her $200,000 basis; the remainder is ordinary income.
Example on rough figures: if the expected return were $350,000, the exclusion ratio would be $200,000 ÷ $350,000 ≈ 57%. On an assumed $1,900 monthly payment, about $1,085 would be excluded and $815 taxable.
Comparison for Yvonne:
- The withdrawal she is considering is 100% taxable because gain comes out first, and it permanently removes money from the contract.
- Annuitization spreads the gain over many years and delivers a guaranteed lifetime income she cannot outlive - valuable at 68 with no Social Security yet.
- But annuitization is generally irrevocable: she loses access to the principal, and if she dies early the remaining guarantee depends on the payout option chosen.
With a one-time $40,000 need and other savings available, a partial withdrawal is the better fit; annuitizing the whole contract would over-correct.